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Ten Mandatory SECURE 2.0 Changes for 401(k) Plans

The SECURE 2.0 Act of 2022, as enacted on December 29, 2022, contains over 90 provisions affecting retirement plans and IRAs, but of the many provisions only a handful are required changes for 401(k) plans.  This post lists those changes and indicates when the provisions go into effect.  Unless otherwise noted, 401(k) plans (and 403(b) plans, to which these changes also apply) will need to be amended to reflect mandatory SECURE 2.0 changes by the end of their 2025 plan year, unless that deadline is later extended.  Note that some of the changes listed below, such as the paper disclosure requirement, may not require a plan amendment.  Also as noted, two are required changes only if discretionary provisions are first adopted.

One.  Increases In Required Minimum Distribution Age

Effective for required minimum distributions (RMDs) after December 31, 2022 for individuals who attain age 72 after that date, the RMD increases from 72 to 73 for those born between 1951 and 1959, and age 75 for those born in 1960 and subsequent.  A technical glitch needs to be corrected, as the law currently puts those born in 1959 into the age 73 and age 75 distribution categories. 

Two. Removal of RMD Requirement for In-Plan Roth Accounts

RMDs during your lifetime are not required for Roth IRAs, but were required under prior law, to be taken from from in-plan Roth accounts.  SECURE 2.0 eliminates the requirement to take lifetime RMDs from in-plan Roth accounts effective for tax years beginning after December 31, 2023. 

Three.  Roth Catch-Up Contributions for High Earners

Effective for tax years beginning after December 31, 2023, age 50 catch-up contributions under 401(k) plans made by participants whose wages in the prior year exceeded $145,000 must be made in the form of designated Roth contributions.  The $145,000 amount is indexed after 2024.  Catch-up contributions for lower wage earners can continue to be made on a pre-tax basis but must be permitted to be made in the form of designated Roth contributions.  Another technical glitch in the law needs to be corrected, in order to make catch-up contributions permissible at all, beginning in 2024.  Plans that don’t include designated Roth contributions must be amended to do so by the applicable deadline, in order to accommodate the Roth catch-up feature.

Four:  Increased Catch-Up Limit Between Ages 60-63

Effective for tax years beginning after December 31, 2024, the age 50 catch-up limit is increased for participants between the ages of 60 and 63 to the greater of (a) $10,000 or (b) 150% of the 2024 “normal” catch-contribution limit.  150% of the 2023 catch-up contribution limit already exceeds $10,000 ($11,250).  The $10,000 limit will be adjusted for cost-of-living after 2025.

Five.  Coverage of Long-Term, Part-Time Workers

This one is a double whammy because SECURE 1.0, enacted in 2019, requires coverage of long-term, part-time employees for 401(k) plans in 2024, and SECURE 2.0 expanded this rule to ERISA 403(b) plans, in addition to reducing the number of years required to qualify as a long-term part-time employee.   Specifically, beginning in 2025 401(k) and ERISA 403(b) plans must allow employees who complete 500 or more hours of service in two consecutive years to make elective deferrals (but need not make employer contributions on their behalf), taking into account service worked in 2023 and subsequent.  Under SECURE 1.0, 401(k) plans must allow employees who worked 500 or more hours in three consecutive years, beginning in 2021, to make elective deferrals commencing in 2024.  These employees need not be taken into account for nondiscrimination and coverage purposes or for top-heavy purposes.

An example illustrates how this works.  An employee who works at least 500 hours of service in 2021, 2022, and 2023 would be eligible to make elective deferrals in their employer’s 401(k) plan on January 1, 2024, per SECURE 1.0.  But if that same employee were employed by an employer with an ERISA 403(b) plan, the employee would have to work 500 or more hours in both 2023 and 2024, in order to be eligible to make elective deferrals in 2025 under SECURE 2.0  Note that this would be the case even if the employee were a student employee or were hired into a position requiring less than 20 hours per week (categories that were exceptions to the universal availability rule applicable to 403(b) plans).  Service for plan years before January 1, 2023 is disregarded for purposes of SECURE 2.0 eligibility, but service worked since 2021 is counted for vesting purposes under both SECURE Acts. 

Six. Auto-Enrollment and Auto-Escalation for Newly Adopted Plans

Effective for single-employer 401(k) or 403(b) plans adopted on or after December 29, 2022 SECURE 2.0 requires that, starting in 2025, the plan auto-enroll participants, and auto-escalate deferrals.  This rule also applies to employers that adopt multiple employer plans on or after December 29, 2022.  Certain exemptions apply, including employers with 10 or fewer employees, businesses in the first three years of existence, governmental and church pans, and SIMPLE 401(k) plans.  For plans subject to the rule, the automatic enrollment percentage must start at 3% and increase at least 1% on the first day of each successive plan year until the deferral rate reaches at least 10%, but not more than 15%.  For plan years beginning before 2025, non-safe harbor plans may not exceed 10%.  Participants must be permitted to withdraw deferrals, and earnings, within 90 days, without application of the 10% early withdrawal penalty tax.  Qualified default investment alternatives must be used for the automatically contributed amounts, subject to modification by participants.  

Seven.  Repayment Deadline for Qualified Birth or Adoption Distributions (If Offered)

This is a mandatory change to a discretionary provision from SECURE 1.0.  SECURE 1.0 introduced the option of allowing participants to take qualified birth or adoption distributions (QBADs), which are distributions from a 401(k) or 403(b) plan (or IRA) of up to $5,000 per parent that are not subject to the early withdrawal penalty tax and that are taken within one year of the date of a birth or finalization of adoption proceedings.  SECURE 1.0 provided that these amounts may be repaid back to the qualified plan or IRA notwithstanding normal contribution dollar limits, but did not specify a deadline for repayment.  For plan sponsors that did add QBADs to their plans, and for IRA custodians that made them available, SECURE 2.0 now requires that repayment be made within three years.  The repayment period ends December 31, 2025 for QBADs that are currently outstanding.

Eight.  Surviving Spouse Election to be Treated as Employee

Surviving spouses have several special options with regard to a spouse’s retirement accounts, that are not available to non-spouse beneficiaries.  Effective for 2024, SECURE 2.0 adds one more option:  the surviving spouse of the account holder who is the designated beneficiary of the account can irrevocably elect to be treated for RMD purposes as the deceased account holder of the retirement account him or herself.  As a consequence, RMDs will be paid no sooner than when the account holder would have reached his or her required beginning date, and will be paid out according to the account holder’s life expectancy, rather than the spouse’s life expectancy, using the Uniform Life Table rather than the Single Lifetime Table.  Note that this option is different from the surviving spouse electing to treat the account as his or her own, which would also result in use of the Uniform Life Table, but using the spouse’s birthdate.  This new option under SECURE 2.0 would primarily be of interest to an older surviving spouse, as it would permit use of the younger account holder’s life expectancy for RMD purposes. 

Nine.  Required Annual Paper Account Statement

Under a Department of Labor “safe harbor” set forth in final Department of Labor regulations published in 2020, retirement plan sponsors may deliver plan disclosures such as Summary Plan Descriptions, quarterly or annual account statements, and other items, by electronic means, either through email or posting on a company website.  EforERISA posted about the electronic disclosure safe harbor back in 2020.  Effective for plan years beginning after December 31, 2025, SECURE 2.0 requires that defined contribution plans, which include 401(k) and 403(b) plans, provide a paper benefit statement at least once per year.  The other three required quarterly statements may be delivered electronically provided the safe harbor delivery requirements are met.  Participants are permitted to opt-out of paper delivery.   SECURE 2.0 also instructs DOL to revise the electronic delivery regulations by December 31, 2024, to require a one-time initial paper notice to new participants that informs them of their right to receive all required disclosures on paper.  This initial written disclosure would be required to be delivered prior to issuance of any electronic communications about the plan.

Ten.  Annual “Reminder” Notice for Unenrolled Participants (Sec. 320)

This is a required provision for employers who opt to use simplified disclosure procedures for employees who are eligible under their plan, but do not actively participate. This is a discretionary provision under SECURE 2.0 and it is unclear how many employers will adopt it, due to the administrative challenges of segregating the two employee populations for different notice purposes. Currently required ERISA disclosures must be made to employees who have met eligibility requirements under a retirement plan, but do not actively participate, equally to those who are actively participating in a retirement plan. Effective immediately, a plan sponsor may carve unenrolled participants out of normal notification procedures, provided that they supply an annual notice of the employees’ eligibility to participate in the plan, and any applicable election deadlines. Other prerequisites to this simplified annual notice procedure are that (a) the employee is provided any notification they expressly request be supplied; and (b) the employee received a Summary Plan Description and all other required notices upon initially becoming eligible to participate in the plan.

If you are a 401(k) or 403(b) plan sponsor, or advise plan sponsors, and have questions about these required changes under SECURE 2.0, use the Contact form at EforERISA to get more information on next steps.

The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2023 Christine P. Roberts, all rights reserved.

Photo credit: Ross Findon, Unsplash

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The Unsung Importance of Self-Correction Memos

Self-correction of operational errors arising in qualified retirement plans is a critical means for plan sponsors to retain their plans’ tax-qualified status. Self-correction has been promoted by the Internal Revenue Service as part of the Employee Plans Compliance Resolution System, or EPCRS, for approximately twenty years, but the rules for self-correction have evolved over that time period, and some essential requirements of self-correction are still little understood. One recommended component of self-correction that can tend to be overlooked is preparation of a self-correction memo. Below I describe what a self-correction memo is, and why preparing one is “best practices” – even if EPCRS does not mandate it.

By way of background, the Self-Correction Program or SCP is one of three component programs of EPCRS available to sponsors of qualified plans, 403(b) plans, SEP or SIMPLE IRA plans. (EPCRS is set forth in a Revenue Procedure that is updated periodically; the current version is Revenue Procedure 2021-30. The other component programs are Voluntary Correction Program or VCP, and the Audit Closing Agreement or Audit CAP.) SCP is available for operational failures (failure to operate a plan in accordance with its written terms) and plan document failures (such as failure to timely adopt a required plan amendment). With regard to operational failures, SCP divides them into two categories: “significant” operational failures, and “insignificant” operational failures. Plan document failures are always treated as significant. Insignificant operational failures are eligible for self-correction at any time. Significant operational failures are eligible for self-correction only if the corrections are both discovered and substantially completed by the last day of the third plan year following the plan year for which the failure occurred. Whether or not an operational failure is significant depends upon a number of criteria that are set forth in Revenue Procedure 2021-30, Section 8.02, including the number of affected participants, versus the total number of participants in the plan as of the Plan’s last filed Form 5500, and the amount involved in the operational failure, versus the total assets in the plan per the last-filed Form 5500. SEP and SIMPLE IRA plans may only self-correct insignificant operational errors.

Other requirements of SCP are as follows:

  • To correct a document failure or a significant operational failure, the qualified plan in question must be the subject of a favorable determination letter (for an individually designed plan) or must be a pre-approved plan that is the subject of a favorable opinion or advisory letter.
  • In addition, the plan sponsor or plan administrator must have established practices and procedure (formal or informal) that are reasonably designed to promote and facilitate overall compliance with Internal Revenue Code requirements, both in form and operation. This may take the form of annual plan administration procedures or guidelines; the plan document alone will not suffice. For SCP to be available, the procedures must have been in place and routinely followed, and the error must have occurred through an oversight or mistake in applying them. This component of SCP is also often overlooked.

What is a Self-Correction Memo?

A self-correction memo is a written memorandum, ideally signed and dated by a representative of the plan sponsor, that does all of the following: (a) describes a plan sponsor’s eligibility to use SCP; (b) describes the operational or document failure(s) and the method(s) of correction; (c) addresses whether or not the error was significant and if so whether it was substantially corrected within the necessary time period; and (d) assembles, as exhibits, all documentation of the error and its correction. Paragraph headings for a self-correction memo for an operational failure may include the following:

  • A description of the operational failure
  • The date that the plan sponsor discovered the operational failure
  • The fact that a favorable letter is in place
  • A description of the plan sponsor’s established practices and procedures for compliance with the Internal Revenue Code
  • A summary of any changes to the plan’s administrative practices designed to prevent the failure from reoccurring
  • A determination that operational errors were insignificant, or significant, following the criteria set forth in Revenue Procedure 2021-30, Section 8.02
  • The correction methodology, with citations to approved EPCRS correction methods, if appropriate
  • The number of affected participants relevant to the number of total participants
  • The manner in which affected participants were notified of the correction
  • A recitation of the actual corrections, including dates and amounts, or attached documentation proving same
  • The bases on which the plan sponsor determined the operational failure to be insignificant, if applicable
  • If the operational error was significant, the dates on which the correction period began and ended
  • If the correction involved transferred assets (which increases the time available for correction), the date of the merger, acquisition, or other similar transaction in which the assets were transferred.

Confirming that your operational failure is eligible for self-correction — and preparing the self-correction memo itself – will often require the guiding hand of an ERISA attorney.

Why is a Self-Correction Memo “Best Practices”?

That is a good question, and there is a common-sense answer. There is nothing in the Revenue Procedure 2021-30 specifically requiring that a self-correction memo be created, but it is best practices because it provides ready proof that the plan sponsor qualified for self-correction and completed all correction steps in accordance with EPCRS. Operational and document failures must be disclosed in a plan audit or during due diligence related to a merger or acquisition involving the plan sponsor. Having a self-correction memo and exhibits to hand in such an event is vastly preferable to simply asserting that self-correction was pursued, without being able to prove that SCP was both available to the plan sponsor, and properly completed within the necessary time period. The listing of recommended topics to cover, above, indicates the volume and specificity of information that is required to take advantage of self-correction. Trying to compile this information under the time pressures of a plan audit or due diligence process, when the information may be difficult to locate or reproduce, is a recipe for failure. It is far preferable to document your self-correction process with a memo as you go along, not unlike cleaning up the kitchen as you cook. You’ll thank yourself later.

The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2022 Christine P. Roberts, all rights reserved.
Photo credit: Dimitri Karastelev, Unsplash


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2023 Retirement Plan Limits Announced

The Internal Revenue Service announced new dollar limits for retirement plans for 2023, with most limits showing a sizeable increase over 2022 amounts. The new annual 401(k) elective deferral limit is $22,500 with a $7,500 catch up for those age 50 or older, permitting $30,000 to be contributed annually, or $5,000 per month. Plan sponsors should also note that the compensation threshold to determine highly compensated employees increases from $135,000, to $150,000, which is measured based on prior year’s compensation. The rest of the new limits are shown below:

The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2022 Christine P. Roberts, all rights reserved.

Photo credit: Rodion Kutsaiev, Unsplash

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CalSavers Scoops Up Micro-Businesses Effective in 2025

Coming close on the heels of expansion of the CalSavers program to businesses with 5 or more employees, which went into effect on June 30, 2022, California Governor Gavin Newsom signed into law a further expansion of the CalSavers program on August 26, 2022, in the form of Senate Bill 1126.  Under this new measure, as of December 31, 2025, businesses with one (1) employee or more must either enroll in the CalSavers program, or sponsor a retirement plan.

This sweeps into the CalSavers regime even micro-businesses like home-based Etsy shops, food trucks, and the like.  Expressly excluded from the expansion are sole proprietorships, self-employed individuals, or other business entities that do not employ any individuals other than owners of the business (a company that employs two spouses, who each own half of the company’s stock, would be one example).

For these very small businesses, enrolling in CalSavers may be preferable to establishing even the simplest format retirement plan, due to the complexities of administering these plans, and the very inflexible rules for the IRA-based retirement plans (SIMPLE and SEP arrangements).  We covered some of the potential pitfalls of setting up a plan in our earlier post. 

That said, the financial services industry is increasingly reaching out to smaller employers with app-based service packages that allow a business owner to establish a 401(k) plan online, with “just a few clicks.”  No matter how easy it is to establish, a 401(k) plan is still a 50+ page written contract that is governed by two federal agencies (Department of Labor and Internal Revenue Service) and caution is advised.  With the proper prior planning, a SIMPLE, SEP, or 401(k) plan can be a powerful means of attracting and retaining employees and a good strategic move for even the smallest business.  But knowing what you are getting into, is key.   The persons vending the plan services may not be your best source of knowledge as to what can go wrong.  Stay on the safe side and check with an expert – either a CPA with retirement plan experience, a 401(k) plan third party administrator, or an ERISA attorney, before you sign plan documentation. 

Finally, classifying someone as an independent contractor to avoid the 1-employee threshold is not a good idea in California, where the criteria for independent contractor are quite narrow.  If you have questions in that regard, check with the California Department of Industrial Relations, or with a qualified employment law attorney.

The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2022 Christine P. Roberts, all rights reserved.

Photo credit: Anthony Persegol, Unsplash

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Will New IRS Funding Increase Plan Audits?

The Inflation Reduction Act, H.R. 5376 stands poised for passage in the House and includes almost $80 billion in new funding for the Internal Revenue Service, of which almost $46 billion is allocated to “enforcement,” including determination and collection of taxes, legal and litigation support. What is not clear at this juncture is how much of that massive amount of new funding will trickle down to the Tax Exempt and Government Entities Division, which has oversight over retirement plans, the employers that sponsor retirement plans, and IRAs. IRS Commissioner Chuck Rettig has stated in letters to both houses of Congress that the rates of auditing households making under $400,000 per year will not increase despite the new funding, but that the resources will enable “meaningful, impactful examinations of large corporate and high-net-worth taxpayers.” Whether this includes examinations of large corporate and high-net-worth taxpayer retirement plans and IRAs is uncertain.

A breakdown of the new IRS funding, which is set forth in Title I, Subtitle A, Part 3 of the Act, is set forth below.

Section 10301. Enhancement of Internal Revenue Service Resources.

It seems hard to imagine that some portion of the enforcement budget won’t ultimately increase plan audit activity. The IRS only recently announced a new plan enforcement initiative in the form of a 90-day Pre-Examination Compliance Pilot program (click on June 3, 2022 to display the program announcement). Under this new program, IRS will send a letter to a plan sponsor notifying them that their retirement plan has been selected for an examination. The letter gives the plan sponsor a 90-day window of time to review their plan’s documentation, and operations, for compliance with applicable law. If errors are noted, they may be eligible for self-correction under the terms of Revenue Procedure 2021-30. Errors that are not eligible for self-correction can be corrected under a closing agreement, with the Voluntary Correction Program fee structure forming a basis to determine the sanction amount that the IRS will impose. If the plan sponsor fails to respond to the IRS within 90 days of the letter, the IRS will contact the sponsor to schedule an exam. Since this audit initiative starts with a simple letter, there would now seem to be ample funds at IRS to pursue this agenda – in fact, postage is one of the expressly sanctioned expenses under Operations Support. Even without a specific funding line-item for TE/GE, plan sponsors should be on their guard in this new era of IRS funding.

The author thanks Peter Gulia, Fiduciary Guidance Counsel, and other colleagues at the Benefitslink Message Boards for sharing their thoughts about the new IRS funding.

The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2022 Christine P. Roberts, all rights reserved.

Photo credit:  Mathieu Stern, Unsplash

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The Slippery Slope of SEP and SIMPLE Notification Duties

As the June 30, 2022 CalSavers deadline bears down on employers with five or more California employees, many small employers may be giving thought to adopting a simplified retirement plan, whether a SEP or SIMPLE IRA.  Establishment of one of these types of plans is a permissible alternative to participating in CalSavers.  There are circumstances where these types of plans are a good fit.  However, each of these types of plans imposes participation notification duties that employers often overlook, and noncompliance can put the tax-sanctioned status of the whole arrangement at risk. Below we summarize the relevant rules.

Simplified Employee Pension (SEP) Notification Duties

IRS Form 5305 is often used to establish a SEP.  A plan set up via Form 5305 is considered adopted when eligible employees have been provided with:

  • a copy of the completed, signed, and dated Form 5305-SEP, including the Instructions to Employer and Information to Employee sections;
  • a statement to the effect that IRAs other than the IRA(s) into which employer contributions will be made may yield different rates of return and may have different terms concerning, among other things, transfers and withdrawals of funds from the IRA;
  • a statement that notice of any amendment to the SEP, a copy of the amendment and a written explanation of its effects, will be provided within 30 days of the effective date of any such amendment; and
  • a statement that the employer will provide written notice of contributions made to the plan, by the later of (a) January 31 of the year following the year in which the contribution is made, or (b) the date that is 30 days after the date the contribution is made.  This notice duty may be met by reporting the SEP contribution on eligible employees’ Form W-2 for a given year.  Failure to provide the notice of contribution may subject the employer to a $50 penalty per failure unless the failure is due to reasonable cause. 

This information must be provided thereafter to each new employee who becomes eligible under the SEP.

Additional disclosure duties apply if you are using a prototype SEP arrangement, rather than Form 5305-SEP, including special disclosures for plans under which contributions are integrated with Social Security.  Providing eligible employees with a copy of the SEP agreement will meet many of the disclosure requirements, but employers should check with the prototype SEP sponsor to confirm that they will timely supply your business with all necessary additional disclosures.  Annual contribution reporting through Form W-2 is the same. 

Savings Incentive Match Plan for Employees (SIMPLE IRAs)

Notification duties under a SIMPLE plan are more complicated than under a SEP due to the employee elective deferral feature.  Also, there are two model SIMPLE forms in use, Form 5304-SIMPLE and Form 5305-SIMPLE.  Form 5304-SIMPLE is used when all IRAs are established with a single designated financial institution, and Form 5305-SIMPLE is used when participants select their own IRA provider.

For an existing SIMPLE IRA plan, eligible employees must receive a Summary Description and Notification to Eligible Employees before the start of a 60-day election period.  Since all SIMPLE plans must be on a calendar plan year, including those set up using Forms 5304- or 5305-SIMPLE, the plan year must be the calendar year.  Therefore the 60-day election period runs from November 2 through December 31, and the notice must be provided before November 2 each year.   Provision of a current copy of the completed Form 5304-SIMPLE or 5305-SIMPLE, with instructions, will satisfy both disclosure duties if Article VI – Procedures for Withdrawals, is completed.  When Form 5304-SIMPLE is in use, the custodian or trustee may provide the Article VI information directly to the employees; employers should confirm that the custodian/trustee is timely meeting this disclosure duty, however. 

For a new SIMPLE IRA plan or for a new hire who becomes eligible, the Model Salary Reduction Agreement that comprises part of Forms 5304- and 5305-SIMPLE must be provided prior to the 60-day period that includes either the date the employee becomes eligible or the day before.  The employee must be able to commence elective deferrals as soon as they become eligible, regardless of whether the 60-day period has ended, but no earlier than the plan’s effective date.  Certain special notification and election period rules apply when an employee becomes an eligible employee other than at the beginning of a calendar year, including when an employee is rehired during a plan year. 

How to Deal with SEP and SIMPLE Mishaps

If you have not timely met your SEP notification duties as outlined above, you should consult an ERISA attorney.

If you have not timely met your SIMPLE-IRA plan notification duties as outlined above, you can fix the problem by following the steps outlined in the SIMPLE IRA Plan Fix-It Guide.  Self-correction may be an option if you had practices and procedures in place to timely provide the notice but failed to follow them, and other pre-requisites to self-correction have been met.  Otherwise, you may need to use the Voluntary Correction Program to fix the problem.  This will generally require the involvement of an ERISA attorney.

In addition to notification duties, SIMPLE plans are subject to rules regarding timing of deposit of employees’ elective deferrals.  Elective deferrals must be deposited with the IRA custodian or trustee within the 30-day period following the last day of the month in which the amounts otherwise would have been payable in cash to employees.

If elective deferrals are not timely deposited, the Department of Labor (DOL) may have to be contacted to correct the problem.  Why is this necessary?   To avoid potential employer liability for civil penalties, and in some cases involving missed or late elective deferrals, criminal penalties. 

Special rules, not addressed above, may apply to plan documents not established using the IRS forms mentioned in this post.

The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2022 Christine P. Roberts, all rights reserved.

Photo credit:  Nico Smit, Unsplash

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Just Adopted a New 401(k) Plan?  Beware These Common Pitfalls

By June 30, 2022, businesses with 5 or more California employees must either enroll in CalSavers, a state-managed system of Roth IRA accounts, or establish their exemption from CalSavers by adopting 401(k) or other retirement plans of their own.  Other states have implemented or are rolling out similar auto-IRA programs.  Below are some potential pitfalls for new plan adopters that business owners should be aware of, and, where possible, take steps to avoid. 

  1. Immediate top-heavy status.  The “top-heavy” rules compare the combined plan account balances of certain owners and officers, called “key employees,” with the plan account balances of all other plan participants (non-key employees).  If the key employee account balances make up 60% or more of the combined plan account balances of all participants, the plan is top-heavy and the plan sponsor is required to make minimum contributions (generally equal to 3% of compensation) to the accounts of all non-key employees.  A plan can be top-heavy in its first year of operation, although it is more commonly a result of large account balances accumulated over time by long-term key employees, versus smaller accounts held by high-turnover, lower paid employees.   Top-heavy status is particularly likely to arise in a family-owned business, as family members of owners count as key employees, but the problem is not limited to this scenario.  Businesses that anticipate a potential top-heavy problem should consider adopting safe-harbor 401(k) plan designs, as a basic safe-harbor matching or non-elective contribution will satisfy minimum top-heavy contribution requirements.  A SIMPLE-IRA plan is also exempt from top-heavy requirements, provided you have 100 or fewer employees.
  2. ADP/ACP testing failure.     A similar and more common problem, failure of the Actual Deferral Percentage or ADP test, occurs when the average rate of elective deferrals made by Highly Compensated Employees exceeds the average rate of elective deferrals made by non-Highly Compensated Employees by more than a permitted amount.  (A related test, the Actual Contribution Percentage test, applies to matching contributions.)  Highly Compensated Employees (HCEs) are persons who own more than 5% of the company sponsoring the plan at any time during the current or prior year, or who, for the prior year, earned above a set dollar amount.  (For 2022, the amount is $135,000 and applies to 2021 earnings.)  Correcting testing failures will involve refunding amounts to HCEs, or making additional contributions to non-HCEs.  Fortunately there are a number of preventive measures to take, including using a safe harbor contribution formula, using a “top 20%” election to define HCEs, using automatic enrollment at a meaningful percentage of compensation (such as 5% or higher), and robust enrollment meetings and tools to engage employees with savings potentials under the plan. 
  3. Late deposit of elective deferrals.  When you run payroll and pull employee elective deferrals from pay, you have a deadline within which to invest them under your 401(k) plan, which is the point at which they are considered to be “plan assets” under ERISA.  Investment is generally is denoted as a “trade date” by your plan’s recordkeeper, whether Fidelity, Vanguard, or the like.   If you have under 100 participants as of the beginning of your plan year (counting those who are eligible to participate even if they don’t actively do so) you have seven business days to get from pay date, to trade date.  For larger plans, the normal deadline to invest is as soon as elective deferrals can reasonably be segregated from your general assets.  (An outside deadline of 15 business days after the end of the month following the month in which the elective deferrals would have been payable in cash applies in the event of extraordinary circumstances interrupting normal payroll functioning.)  If you fail to meet the seven business-day or “as soon as” deposit deadline, your retention of employee funds constitutes a “prohibited transaction” and an excise tax is payable to the IRS. Additionally, the Department of Labor views it as a fiduciary breach.  It is possible to seek relief from the excise tax and from potential fiduciary liability by participating in the Department of Labor’s Voluntary Fiduciary Compliance Program or VFCP.  Late deposits of employee elective deferrals (and loan repayments) must be disclosed each year on your Form 5500 Return/Report, which in turn could trigger further inquiry, so compliance with your applicable deposit deadline is important.
  4. Plan audit requirement.  As we covered in an earlier post, a business sponsoring a brand new 401(k) plan may be required to obtain an audit report on the plan’s operations and finances, prepared by an independent qualified public accountant or IQPA, at an annual expense of $5,000 – $15,000 or more.  These reports generally are required for plans with 100 or more participants as of the first day of the plan year, counting those who are eligible to participate whether or not they actually do so.  Proposed regulations for Form 5500 might change that rule, to count only those with plan account balances, but they have yet to be finalized and put into effect.  Until that time, businesses sponsoring new plans that will cover 100 or more eligible participants need to prepare for the audit process, both in terms of budgeting dollars for the cost, and time to gather responses to the auditor’s questionnaires.  New auditing standards going into effect this year put increased responsibilities on plan sponsors to account for plan operations and documentation.

The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2022 Christine P. Roberts, all rights reserved.

Photo credit:  Goh Rhy Yan, Unsplash

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How to Prepare Business Owners for the Approaching CalSavers Deadline

CalSavers is a state-run retirement program that applies to employers who do not already sponsor their own retirement plan.  It automatically enrolls eligible employees in a state-managed system of Roth IRA accounts. It has been in place since September 30, 2020 for employers with more than 100 employees and since June 30, 2021 for employers with more than 50 employees.  On June 31, 2022, it goes into effect for employers with 5 or more employees.  Below we cover key aspects of the CalSavers program, focusing on the types of issues that California business owners might bring to their benefits advisor for further clarification. A version of this post was published in the March 2022 issue of Santa Barbara Lawyer magazine.

Q.1:  What is CalSavers?

A.1:  CalSavers is the byproduct of California Senate Bill 1234, which Governor Brown signed into law in 2016. It is codified in Title 21 of the California Government Code and in applicable regulations. It creates a state board tasked with developing a workplace retirement savings program for private for-profit and non-profit employers with at least 5 employees that do not sponsor their own retirement plans (“Eligible Employers”).  Specifically, CalSavers calls for employees aged at least 18, and who receive a Form W-2 from an eligible employer, to be automatically enrolled in the CalSavers program after a 30-day period, during which they may either opt out, or customize their contribution level and investment choices.   The default is an employee contribution of 5% of their wages subject to income tax withholding, automatically increasing each year by 1% to a maximum contribution level of 8%. Employer contributions currently are prohibited, but they may be allowed at a later date.

Q.2:  If a business wants to comply with CalSavers, what does it need to do?

A.2:  The steps are as follows:

  • Prior to their mandatory participation date – which as mentioned is June 30, 2022 for employers with 5 or more employees, Eligible Employers will receive a notice from the CalSavers program containing an access code, and a written notice that may be forwarded to employees. Eligible Employers must log on to the CalSavers site to either register online, or certify their exemption from Calsavers by stating that their business already maintains a retirement plan. The link to do so is here. To do either, the employer will need its federal Employer Identification Number or Tax Identification Number, as well as the access code provided in the CalSavers notice. 
  • Eligible Employers who enroll in CalSavers will provide some basic employee roster information to CalSavers. CalSavers will then contact employees directly to notify them of the program and to instruct them about how to enroll or opt-out online. Those who enroll will have an online account which they can access in order to change their contribution levels or investment selections.
  • Once an Eligible Employer has enrolled in CalSavers, their subsequent obligations are limited to deducting and remitting each enrolled employee’s contributions each pay period, and to adding new eligible employees within 30 days of hire (or of attaining eligibility by turning age 18, if later).
  • Eligible Employers may delegate their third-party payroll provider to fulfill these functions, if the payroll provider agrees and is equipped to do so.  CalSavers provides information on adding payroll representatives once a business registers.

Q.3:  How does a business prove it is exempt from CalSavers?

A.3:  There are several steps:

  • First, it must have a retirement plan in place as of the mandatory participation date.  This may mean a 401(k) plan, a 403(b) plan, a SEP or SIMPLE plan, or a multiple employer (union) plan. 
  • Employers with plans in place must still register with CalSavers to certify their exemption.  The link is at https://employer.calsavers.com (Select “I need to exempt my business” from the pull-down menu.)  They will need their federal Employer Identification Number or Tax Identification Number and an access code that is provided on a notice they should have received from CalSavers.  If they can’t find their notice, they can call (855) 650-6916.  

Q.4:     How does a business count employees, for the 5 or more threshold?

A.4: To count employees for purposes of the 5 or more threshold, a business takes the average number of employees that it reported to the California Environmental Development Department (EDD) for the previous calendar year.  This is done by counting the employees reported to the EDD on Form DE 9C, “Quarterly Contribution Return and Report of Wages (Continuation)” for the quarter ending December 31 and the previous three quarters, counting full- and part-time employees.   So, for example, if a business reported over 5 employees to EDD for the quarter ending December 31, 2021 and the previous three quarters, combined, and it did not maintain a retirement plan, it would need to register with CalSavers by June 30, 2022.  If a business uses staffing agencies or a payroll company, or a professional employer organization, this will impact its employee headcount. The business should seek legal counsel as the applicable regulations are somewhat complex.

Q.5: What are the consequences of noncompliance with CalSavers requirements?

A.5:  There are monetary penalties for noncompliance, imposed on the Eligible Employer by CalSavers working together with the Franchise Tax Board. The penalty is $250 per eligible employee for failure to comply after 90 days of receiving the CalSavers notification, and $500 per eligible employee if noncompliance extends to 180 days or more after the notice.  CalSavers has begun enforcing compliance with the program in early 2022, for employers with more than 100 employees who were required to enroll by the September 30, 2020 deadline.   

Q.6:  Are there any legal challenges to CalSavers?

A.6:  Yes, but the main suit challenging the program has exhausted all appeals, without success. A bit of background information is necessary to understand the legal challenge to CalSavers. The Employee Retirement Income Security Act of 1974 (ERISA) generally preempts state laws relating to benefits, but a Department of Labor “safe harbor” dating back to 1975 excludes from the definition of an ERISA plan certain “completely voluntary” programs with limited employer involvement. 29 C.F.R. § 2510.3-2(d).  The Obama administration finalized regulations in 2016 that would have expressly classified state programs like CalSavers, as exempt from ERISA coverage, and thus permissible for states to impose. However, Congress passed legislation in 2017 that repealed those regulations, such that the 1975 safe harbor remains applicable. Arguing that the autoenrollment feature of CalSavers program makes CalSavers not completely voluntary and thus takes it out of the 1975 regulatory safe harbor, a California taxpayer association argued that ERISA preempts CalSavers.   On March 29, 2019, a federal court judge concluded that ERISA did not prevent operation of the CalSavers program, because the program only applies to employers who do not have retirement plans governed by ERISA.  The Ninth Circuit affirmed.  In late February 2022, the Supreme Court of the United States declined to review the case. Meanwhile, state-operated IRA savings programs are underway in a number of other states, including Oregon, Illinois and New York, and in the formation stages in yet others. 

Q.7:  Does CalSavers apply to out-of-state employers? 

A.7:  It can.  An employer’s eligibility is based on the number of California employees it employs, as reported to EDD. Eligible employees are any individuals who have the status of an employee under California law, who receive wages subject to California taxes, and who are at least 18 years old. If an out-of-state employer has more than 5 employees meeting that description, as measured in the manner described in Q&A 4, then as of June 30, 2022 it would need to either sponsor a retirement plan, or register for CalSavers.

Q.8.  Does CalSavers apply to businesses located in California, with workers who perform services out of state? 

A.8:  Yes, if the employer is not otherwise exempt, and if they have a sufficient number of employees who have the status of an employee under California law, who receive wages subject to California taxes, and who are at least 18 years old.

Q.9: Can an employer be held liable over the costs, or outcome of CalSavers investments?

A.9:  No.  Eligible Employers concerned about lawsuits should be aware that they are shielded from fiduciary liability to employees that might otherwise arise regarding investment performance or other aspects of participation in the CalSavers program.  In that regard, the CalSavers Program Disclosure Booklet, available online, goes into significant detail about the way CalSavers contributions will be invested; notably the cost of these investments (consisting of an underlying fund fee, a state fee, and a program administration fee).

Q.10:  Can an employer share its opinions about CalSavers, to employees?

A.10.  Not really.  Eligible Employers must remain neutral about the CalSavers program and may not encourage employees to participate, or discourage them from doing so. They should refer employees with questions about CalSavers to the CalSavers website or to Client Services at 855-650-6918 or clientservices@calsavers.com.

The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2022 Christine P. Roberts, all rights reserved.

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When is a 401(k) Not a Retirement Plan?                 

Short answer – a 401(k) plan is not a “retirement plan” for California creditor protection purposes when it was expressly set up to protect IRA rollover assets from creditors. This was the holding in a 2019 California Court of Appeal decision that is still valid law and that is worth revisiting: O’Brien v. AMBS Diagnostics, LLC, 38 Cal. App. 5th 553, 562 (2019), rev. den. 2019 Cal. LEXIS 8003 (October 23, 2019)

Mr. O’Brien got into a legal dispute with his former business partners in AMBS Diagnostics, LLC (AMBS) and lost at trial, resulting in a judgment against him for over $600,000.  AMBS sought to collect on its judgment and filed notices of levy against Mr. O’Brien’s assets, including four IRA accounts then valued at $465,350.  (There was no dispute that the IRA funds had originally been set aside for retirement purposes.)  The court ordered an assessment of what portion of the funds in O’Brien’s IRAs were necessary for his support in retirement and what portion could be used to satisfy the judgment.

This is because, under California Code of Civil Procedure (C.C.P.) § 704.115(a)(3), IRA funds, and funds held in self-employed retirement plans, are exempt from creditors “only to the extent necessary to provide for the support of the judgment debtor,” and their spouse and dependents, upon retirement. This is to be distinguished from protection from bankruptcy creditors, which is governed by federal law (and which exempts up to $1 million, indexed for inflation), and is further to be distinguished from protection of assets held in “[p]rivate retirement plans” that are “established or maintained by private employers or employee organizations, such as unions,” including “closely held corporations.”  Assets held in this fashion are fully protected from creditors under C.C.P. § 704.115(b).  The I.R.S. generally can invade such assets pursuant to a federal tax lien, but that was not at issue in the O’Brien case. 

Mr. O’Brien was aware of the different degree of creditor protection under California law, accorded to IRAs versus employer-sponsored retirement plans.  Accordingly, within 18 days the court order to assess the IRA assets for necessity in retirement, Mr. O’Brien set up a limited liability company and formed a 401(k) plan for the LLC.  He then rolled over his IRA assets to the newly-established 401(k) plan, and then dissolved the LLC.  He also somehow got on the record as admitting that he took these actions to protect his IRA assets from his creditors. AMBS sought to levy funds from the new 401(k) plan but the trial court sided with O’Brien, holding that the funds were fully exempt as held in a “retirement plan” notwithstanding the plan’s recent vintage.

The Court of Appeal reversed on the grounds, in part, that the full exemption available to a retirement plan rests on the assumption that the plan holding the funds was principally or primarily designed and used for retirement purposes, and in light of Mr. O’Brien’s admission the LLC’s plan simply did not meet that standard. “O’Brien freely admitted his subjective intent for creating the 401(k) plan and in transferring the funds . . . ‘[T]he shielding and hiding of assets from creditors is clearly not a “use for retirement purposes.”’”  38 Cal. App. 5th at 562, citing In re Daniel, 771 F.2d 1352, 1358 (9th Cir. 1985), In re Dudley, 249 F.3d 1170, 1177 (9th Cir. 2001), In re Bloom, 839 F.2d 1376, 1378 (9th Cir. 1988).  The court concluded that the 401(k) funds were still subject to the more limited, “as necessary for retirement” protection available to IRA assets and sent the matter back to the trial court for assessment of the funds against that standard, as originally had been intended.  Interestingly, in reaching this conclusion the court favorably cited an earlier decision, McMullen v. Haycock, 147 Cal. App. 4th 753, 755-756 (2007), in which funds in a retirement plan account were held to have kept their higher level of protection against creditors after having been rolled to an IRA.  This “tracing rule” remains citable legal authority in California although it is somewhat at odds with the language of C.C.P. § 704.115(a)(3). 

Would the outcome in the case have been different had O’Brien not been so bold about stating his intentions?  Probably not, though he certainly did not help himself.  The timing of the LLC and plan setup were damning enough in themselves, and it would appear from the opinion that the rollovers were made in violation of the 401(k) plan terms (AMBS alleged that “O’Brien’s purported rollover of funds was invalid because he did not meet the qualifications set forth in the 401(k) plan itself for such a rollover.”)  58 Cal. App. 5th at 558.

Clearly, a poor plan, poorly executed, and an object lesson that creditor protection of retirement plan assets will be based on all the relevant facts and circumstances, not just the name on the account.

The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2021 Christine P. Roberts, all rights reserved.

Photo credit: Sasun Bughdaryan, Unsplash

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IRS Announces 2022 Retirement Plan Limits

On November 4, 2021, the IRS announced 2022 cost-of-living adjustments for annual contribution and other dollar limits affecting 401(k) and other retirement plans.  The maximum annual limit on salary deferral contributions to 401(k), 403(b), and 457(b) plans increased $1,000 to $20,500, but the catch-up contribution limit for employees aged 50 and older stayed the same at $6,500.  That raises the total deferral limit for a participant aged 50 or older to $27,000.  The Section 415(c) dollar limit for annual additions to a retirement account was increased to $61,000 from $58,000, and the $6,500 catch-up limit increases that to $67,500 for participants aged 50 or older.   In addition, the maximum limit on annual compensation under Section 401(a)(17) increased to $305,000 from $290,000, and the compensation threshold for Highly Compensated Employees increased to $135,000, from $130,000.  Other dollar limits that increased for 2021 are summarized below; citations are to the Internal Revenue Code.  Unchanged were the annual deductible IRA contribution and age 50 catch-up limit ($6,000 and $1,000, respectively), and the age 50 SIMPLE catch-up limit of $3,000.  In a separate announcement, the Social Security Taxable Wage Base for 2022 increased to $147,000 from the prior limit of $142,800 in 2021.

Photo credit: Atturi Jalli, Unsplash.